Your employer-sponsored account is one of the best places to save for your retirement. The No. 1 reason I encour- age most investors to participate in their 401(k) is that many employ- ers provide participants an employee match up to a certain percentage of salary.
This is free money - a 100 percent return on your investment. I don't know of any other place where you can get that type of return. Additionally, contribution limits are very generous at $19,000 for 2019, with an additional $6,000 for in- vestors age 50 and older.
Once you decide to participate, there are still options: Do you participate in the traditional 401(k) or the Roth 401(k) if it is available? Traditional 401(k) con- tributions come out of your paycheck be- fore the tax calculation; therefore, they lower your taxable income today. With- drawals from the traditional 401(k) are taxed as ordinary income in retirement. With Roth 401(k) contributions, you do not get a current tax break, as they're taken from your paycheck after taxes have been withheld, but you get tax-free withdrawals in retirement beginning at age 591/2 provided the account has been held for at least five years. Keep in mind that your employer contributions will be placed in the pre-tax 401(k) - as they are deductible for your employer - so you will still have a mix of tax-free and tax-deferred savings.
Let's look at some math: If you're 30 and you contribute $2,500 annually to your Roth 401(k), you potentially have 29 1/2 years or more for that contribu- tion to grow tax-free. If your long-term growth rate averaged 7 percent annually, your $2,500 annual contributions could grow to about $244,215. If you retire at 67 when you are considered "full retire- ment age" for Social Security benefits, your contributions could grow to around $436,773, assuming the same 7% long- term annualized growth rate. Furthermore, that balance in your Roth is yours to keep because taxes were paid years prior. If you made the same contribution to your traditional 401(k), your balance would be subject to ordinary income tax rates upon withdrawal, making it considerably less. Let's say your marginal tax rate was 24% in retirement (that's using one of today's rates - who knows what taxes we'll be paying in the future), your balance of around $436,773 is more like $331,947 after tax.
If you are limited to a traditional 401(k), and save the money that you otherwise would have paid in taxes (about $600 per year assuming a constant 24% tax rate) to an after-tax account and earn the same 7% annually, you could "break even" at the end of the period between the traditional and Roth. However, sav- ing that excess is easier said than done for most people.
The younger you are, the more attractive the Roth option can be because of the years of compounding growth you have ahead of you. You may be in a lower tax bracket because you're early in your career, so the tax break today provided by traditional contributions may not be as significant as it could be later when you are earning more.
Still, for older investors, the Roth op- tion has some advantages. Roth 401(k)s do not have income limitations. Those later in their career may be earning more, preventing them from contributing to a Roth IRA. While high earners are allowed to convert traditional IRA funds to a Roth IRA, that is a taxable transaction that needs to be paid from funds outside of the IRA.
Unfortunately, the Roth 401(k) doesn'i have the same ?exibility of a Roth IRA. Withdrawals are generally required at age 701/2 unless you roll the balance into a Roth IRA once you retire, and you can't withdraw contributions at any time. Also, something to keep in mind ii you're starting late is that at age 591/2, your distribution w0n't be qualified unless you've held the account at least five years. The best news is that you can split the difference and contribute to both the traditional and Roth accounts, which will diversify your tax situation in retirement.
William G. Lako, Jr., CFP®, is an Exec- utive in Residence at Kennesaw State University's
Coles College of Business and a principal at Henssler Financial and a co- host on At1anta's longest running, most
respected financial talk radio show "Money Talks" airing Saturdays at 10 a.m. on AM920 TheAnswer. Mr. Lako is a Certi-
fied Financial Planner" professional.